Let's Scrap Mark-to-Market Accounting

Richard Lehmann, editor of the Forbes/Lehmann Income Securities Investor, explains why mark-to-market accounting has played a big role in the financial crisis.

You may have heard various commentators make passing remarks about “a mark-to-market” accounting rule and how this rule needs to be changed or even suspended. I first advocated such a step in February 2008, to little effect.

The advocates of mark to market point out the need for “transparency” in financial statements, especially in the current environment where billion-dollar write-offs are a weekly occurrence.

Accounting principles are meant to give transparency and uniformity in financial reporting, critical elements in providing the confidence needed for security investments. Equally important, however, is that those principles also provide accuracy in reporting.

An accounting rule is dangerous when it becomes the main reason for a transaction to occur. In the mortgage debacle, the effect of mark-to-market valuations was massive, leading to ever-increasing downward pressure on prices as rule-based write-downs created more desperate sellers and caused increasing uncertainty as to what the real values were.

Under mark-to-market accounting, a $100,000 mortgage had to be written down to $20,000 without [knowledge of whether] a foreclosure was imminent, if the mortgage could be restructured, or what the underlying property could resell for. Market price was driven down solely by the lack of buyers rather than these fundamentals.

In the current environment, mark-to-market accounting is forcing financial institutions to recognize immediately anticipated foreclosure losses on the portfolio, even though such losses are not yet knowable. The interest income from that portfolio, however, is not allowed to be recognized except as it is earned.

The distortion in fair valuation that this causes leads to financial institutions having to report massive losses, most of which would normally never be realized. This in turn leads to a collapse of their stock price, which leads to new capital coming in at bargain prices (i.e., the government bailout) or a merger with another company.

Alternatively, the government bails out the company by buying the mortgages at their artificially written-down value—a classic case of an accounting rule becoming a self-fulfilling prophecy. (The Financial Accounting Standards Board, which sets accounting rules, is addressing the issue under Congressional pressure—Editor.)

By suspending the mark-to-market rule, holders of the mortgages would value them at their original cost. As mortgage foreclosures take place, a loss experience factor becomes apparent and the valuation of the mortgage portfolio is then written down to reflect that experience factor.

Billions of dollars of taxpayer money had to be injected into financial institutions to offset the billions of dollars of mark-to-market accounting losses. Without one, you would not have needed the other and the systemic shocks we have been going through would have been much better contained. But of course this can’t be right. After all, Washington only deals in complicated remedies, so the solution can’t be this simple.